Despite $63 Billion In Profits, Here's Why Wall Street Is Still A Joyless Place

Oct. 3 (Bloomberg) — Four years ago today, President George W. Bush signed into law the biggest corporate rescue in American history. Even as U.S. unemployment has remained above 8 per cent for 43 months, the country’s biggest banks are making almost as much as they ever have.

The combined $63 billion in profit reported by the six largest U.S. lenders over the four quarters through June is more than they earned in any calendar year since the peak in 2006.

Bank of America Corp. made more in the 12-month period than Walt Disney Co. and McDonald’s Corp. combined. Citigroup Inc., which like Bank of America took $45 billion in taxpayer funds from the Troubled Asset Relief Program, earned more than Caterpillar Inc. and Boeing Co. JPMorgan Chase & Co., the largest U.S. bank by assets, had profits of more than $17 billion even after reporting a $5.8 billion trading loss.

Still, Wall Street isn’t enjoying its good fortune.

Those billions of dollars in profits aren’t enough, according to interviews with more than a dozen bank executives and analysts. The lowest leverage in a decade, return on equity at a third of 2006 levels, higher capital requirements, shares trading below book value, declining bonuses, job cuts, the European sovereign-debt crisis and a backlash against bankers have damped the joys of profit, they said.

Country Club
Dick Kovacevich, who retired as chairman of Wells Fargo & Co. in 2009, was in the men’s dining room of his San Francisco country club in July after the bank reported a $4.6 billion second-quarter profit.

A man there spoke to him, and not to offer praise for the best results in the firm’s 160 years.

“Wall Street was bailed out, and Main Street wasn’t,” he told Kovacevich, the 68-year-old banker said in an interview.

Wells Fargo and JPMorgan both broke profit records in 2011 and are expected to do so again next year, according to analysts’ estimates compiled by Bloomberg.

“While there are things to celebrate for the senior professionals in these institutions, sadly I don’t think they do much celebrating,” Ralph Schlosstein, chief executive officer of New York-based boutique investment bank Evercore Partners Inc., said of the biggest financial firms. “The challenge they face is how to adjust to this new capital regime, and the new regulatory regime, and to earn an adequate return on equity. None of them have yet broken the code.”

Frosted Cookies
When JPMorgan, which earned the most of any of the six banks over the four quarters, decided to thank employees for their performance this year, it sent 161,680 individually wrapped buttercream-frosted, chocolate chip, oatmeal-raisin and sugar cookies to retail branches and call centres in the U.S., U.K., Philippines and India.

The gifts were delivered in May, two weeks after CEO Jamie Dimon announced what he called an “egregious” trading loss. The cost of the cookies, $130,000, equals about what the lender earned in 3.4 minutes in the second quarter.

“We celebrate in a very low-key way,” said Gordon Smith, JPMorgan’s co-CEO of consumer and community banking.

JPMorgan gets more attention for the trading loss than for its profits, Schlosstein said, and “there’s an element of unfairness to that.”

Talk of unfairness to banks so soon after the financial crisis confounds Michael Greenberger, a former director of markets at the Commodity Futures Trading Commission.

“When the banks say, ‘We’re doing very well but not getting a return on our capital,’ it’s completely incomprehensible, and it’s angering to the average American,” said Greenberger, who teaches derivatives at the University of Maryland’s law school. “They’re making billions of dollars in profits. That’s the bottom line.

Profit Records
The $63 billion profit for the 12 months ended June 30 was exceeded only in calendar years 2005 and 2006, when combined net income was $68 billion and $83 billion. While the latest figure is about half of what the six banks earned in 2006 when firms purchased during the financial crisis are included, they are still among the nation’s biggest money-makers. Fewer than 20 companies, including the banks, made $10 billion in the four quarters though June.

The six financial firms will have combined profits of $9.9 billion in the third quarter, $17.4 billion in the last three months of the year and $75.8 billion in 2013, according to estimates of analysts compiled by Bloomberg. The firms report third-quarter results later this month.

‘Big Problem’
“I’m not surprised,” said Andrew Lo, a finance professor at the Massachusetts Institute of Technology’s Sloan School of Management. “Our country and our government have spent a lot of money stabilizing the banking industry.”

Lo, who’s also chairman of money-management firm AlphaSimplex Group LLC in Cambridge, Massachusetts, said that government support, including TARP and the Federal Reserve’s quantitative easing, is “doing what it’s supposed to.”

Profit tells only part of the story, said Chris Wheeler, an analyst at Mediobanca SpA in London. What strikes closer to Wall Street’s core is return on equity, a measure of how efficiently a company generates income, he said.

“The big problem is the return they’re making on shareholders’ equity,” Wheeler said.

Banks increased leverage, a measure of how much they’ve borrowed, to boost returns before the financial crisis. Morgan Stanley’s leverage, or assets-to-equity ratio, exceeded 33 in 2007, meaning that a 3 per cent drop in the value of the New York-based firm’s assets would have wiped out shareholders. The ratio has stayed below 15 since the third quarter of last year, bringing return on equity down with it.

Capital Cushions
Wells Fargo’s second-quarter return on equity, the highest of the six banks, was more than 12 per cent. The figures for Citigroup, Bank of America, Goldman Sachs Group Inc. and Morgan Stanley were less than half of that. Those five banks had returns above 11 per cent for six consecutive years last decade.

One reason returns have fallen is that regulators have said banks will have to maintain bigger capital cushions to protect against losses. Tangible common equity, a measure that ignores intangible assets such as goodwill, has doubled at the six banks since 2007. It was 7 per cent of total assets on average in the second quarter, an increase of 88 per cent over the five years.

Equity at U.S. banks was about 20 per cent of assets a century ago, according to data compiled by the Fed.

Revenue Squeeze
Revenue also is being squeezed by low interest rates and the 2010 Dodd-Frank Act, which includes caps on debit-card fees that have cost the biggest U.S. lenders about $8 billion a year.

“The problem is you’re simultaneously reducing the amount of leverage in the system at the same time you’re limiting revenues for these larger banks,” said Keith Leggett, senior economist at the American Bankers Association, a Washington- based lobbying group.

The compression of net-interest margins is among the top reasons for declining revenue, according to Leggett. Banks had benefited after the Fed cut its federal funds target rate to almost zero in 2008, borrowing cheaply while collecting interest on existing loans. New loans at lower rates erode profit.

The “very low interest-rate environment that bailed these guys out was also a curse,” said Paul Miller, a bank analyst at FBR Capital Markets Corp. in Arlington, Virginia.

Miller, a former examiner for the Federal Reserve Bank of Philadelphia, said lenders also are facing mortgage putbacks. Fannie Mae and Freddie Mac have been reviewing soured loans for signs of faulty underwriting. The government-controlled firms asked banks to buy back mortgages with an unpaid principal balance of $18.9 billion in the first half of the year.

The banks have said they expect fewer loans to go bad, a forecast that helps them boost earnings.

‘Not Sustainable’
JPMorgan’s consumer and community-banking unit, the one that sent out the cookies, includes a retail division that cut $555 million in the second quarter from an allowance covering future loan losses. That translates into a gain in pretax earnings. In the same period the previous year, the bank added about $1 billion to that sum, an addition treated as an expense.

The $1.55 billion swing was more than one-fifth of the company’s pretax income for the three months.

While Smith, the unit’s co-CEO, said the decline in the allowance is “a very good thing” because it shows the health of the firm’s portfolio, some analysts question the quality of earnings from reduced losses.

“It’s their money, but it’s not coming from operations,” said Shannon Stemm, an analyst at Edward Jones & Co. in St. Louis. The gains are “definitely not sustainable,” she said, because there’s a limit to how far the reserves can decline.

Accounting Gains
JPMorgan wasn’t alone in profiting from loan-loss accounting. A $1.48 billion decline from a year earlier in Bank of America’s provision amounted to more than 40 per cent of the firm’s $3.4 billion second-quarter pretax income.

Other accounting measures helped produce Bank of America’s profit in last year’s third quarter, one of its best ever for the Charlotte, North Carolina-based company. Results were skewed by one-time pretax gains, including $4.5 billion in adjustments of structured liabilities, $3.6 billion from selling a stake in China Construction Bank Corp. and $1.7 billion tied to changes in the value of the firm’s debt.

Banks have been forced to cut compensation to sustain earnings. Those costs fell at Morgan Stanley in the second quarter by about $1 billion from a year earlier to $3.63 billion. That reduction was bigger than the New York-based company’s $940 million pretax profit in the period.

Goldman Sachs said it will cut $500 million of expenses this year, mostly from compensation.

Job Cuts
The six lenders announced at least 40,000 job cuts in the year through June, according to data compiled by Bloomberg. Bonuses fell by more than 20 per cent last year from 2010 at the major commercial and investment banks, compensation-consulting firm Johnson Associates Inc. said in a report.

Concerns that earnings at the biggest banks are under pressure continue to weigh on the companies’ stock prices. While Bank of America’s shares have climbed 61 per cent this year, the most of any of the six firms, and Citigroup’s are up 26 per cent, all six banks are trading at a lower price than five years ago.

Citigroup shares have fallen more than 90 per cent since Oct. 1, 2007, Bank of America is down more than 80 per cent and Morgan Stanley more than 70 per cent.

‘Banking Crisis’
Those three banks, along with Goldman Sachs, are trading at a discount to tangible book value, which means investors value the company less than what shareholders would receive if it were liquidated. Citigroup’s price-to-tangible-book ratio is 0.64, the lowest of the six. Five years ago, all traded at a multiple of tangible book.

“We may be on the verge of a new kind of banking crisis, and that’s a banking crisis where no one wants to own any banks as an investor,” said John Garvey, head of the financial- advisory practice at PricewaterhouseCoopers LLP in New York. “The future looks very dim.”

Greenberger, the University of Maryland law professor, said investors have little confidence in banks because they’ve grown since the financial crisis and have managed to delay or water down regulation.

“The reason their current and prospective investors are concerned is that there’s every likelihood that what happened in 2008 will repeat itself,” he said, calling the rigging of global interest rates and JPMorgan’s trading loss evidence of systemic instability.

Doubled Assets
Total assets at the six banks have more than doubled to $9.41 trillion in the second quarter from $3.75 trillion at the end of 2002 and rose 14 per cent from $8.22 trillion in 2007.

On Sept. 25, the fourth anniversary of the collapse of Washington Mutual Inc., the biggest bank failure in U.S. history, the International Monetary Fund warned in a report of “risks in the financial system,” citing “the larger size of financial institutions.”

WaMu was seized by regulators and sold to JPMorgan, which also bought Bear Stearns Cos. in 2008. Wells Fargo bought Wachovia Corp. that year, and Bank of America acquired Merrill Lynch & Co.

“The people who were at the heart of the financial crisis because of their risk-taking were the ones who came out on the top,” said former U.S. Senator Ted Kaufman, a Delaware Democrat who co-sponsored a 2010 measure that would have shrunk banks.

Cobb Salad
Expensive regulation, not size, is hurting the banks and by extension the economy, according to Wells Fargo’s Kovacevich.

“We charge our customers more, and still our returns are low,” said Kovacevich, who served as the bank’s CEO from 1998 to 2007. “The industry has to extract from the marketplace higher levels of profits, which is an expense to the marketplace, to get still-record-low returns on equity. Is that good for the economy? No.”

At the country club, where he said he golfs twice a week and prefers the Cobb salad, he answered the bailout remark. He told the man that his bank didn’t want the $25 billion it took from TARP and that it repaid the loan with interest.

The conversation ended there.

“Now, if he would’ve argued about it,” Kovacevich said, “I probably would have got a little more animated.”

To contact the reporter on this story: Max Abelson in New York at [email protected]

To contact the editor responsible for this story: David Scheer at [email protected]

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